What is the Federal Reserve?

Dry cleaning isn’t actually dry. Peanuts aren’t really nuts. And Koala bears are marsupials, not bears. On the same level as these bizarre misnomers, sits the Federal Reserve.

Perhaps, the misunderstanding begins with its name. While the name might create the impression that it’s a public entity whose actions are subject to the President or other elected officials, it is actually an independent entity within the United States government.

The Federal Reserve has a profound impact on our nation’s monetary system. Among other things, the Fed is tasked with moderating interest rates, managing the nation’s money supply, and keeping the rate of inflation low and stable. Despite its integral role in our monetary system, the Fed’s makeup and functionality are largely misunderstood by the average US citizen. It seems to me that we should all have a better understanding of how out nation’s central banking system works.

For that reason, I’d like to take a closer look and demystify three basic aspects of the Federal Reserve:

1. What is the Federal Reserve?

2. Why is the Federal Reserve important?

3. Is the Federal Reserve a good thing or a bad thing?

What is the Federal Reserve?

Crisis has historically led to reactionary legislation in America. Just as the Patriot Act followed the terrorist attacks on 9/11, economic crisis led to the passing of the Federal Reserve Act of 1913.

The Panic of 1907, also known as the Knickerbocker Crisis, was a three-week period where the New York Stock Exchange collapsed. The Knickerbocker Trust Company had misappropriated funds into an unsuccessful copper scheme which ultimately to the company’s financial downfall. After learning of Knickerbocker’s collapse, the public rushed to withdraw deposits from New York city banks. The inability to service these withdrawals sparked even greater panic in the markets.

With few people willing to keep their money with the banks, JP Morgan and other heavy hitting bankers stepped up and pumped money into the banks to keep the banking system from completely collapsing. This desperate move helped soften the blow of the economic crisis, but by then a considerable damage had already been done.

In the wake of this financial disaster, powerful bankers lobbied for a central bank that would be tasked with responding to impending financial crisis and mitigating future chaos with sound regulation.

The Anatomy of The Federal Reserve

Imagine your child is on a little league team. Now, let’s say you are in charge of selecting the team’s head coach. Although you aren’t physically coaching the team, you still have significant control over the team’s head coach. You might not tell him how to set the lineup or what moves to make during each game, but the coach’s decisions must largely meet your approval. If they don’t, you’ll replace him. This creates ambiguity when it comes to exactly which decisions the coach is making because he or she thinks they’re right for the team and which decisions are made to appease you. Who’s really in charge here?

Similarly, there’s some grey area when it comes to the relationship between the US government and the Fed.

The President appoints board members of the Federal Reserve, subject to Congressional approval. Those boards members are tasked with making major decisions regarding our nation’s monetary systems and policies. These appointees typically personify philosophies consistent with the elected officials who appoint them. This appointment system gives the US government basic control over the philosophy and general movement of the Fed, but Congress doesn’t have power to micromanage their daily activities. For this reason, many refer to the Fed as a hybrid entity. Logistically speaking, it’s one half federal, the other half private.

The official term for the board of governors is “The Federal Reserve Board.” Twice a year, the Chairman reports to the US government to provide updates on current objectives and ongoing financial issues. These “checkups” are part of the Federal Reserve’s overall incomplete independence from the government.

The Federal Reserve System is comprised of a network of 12 Federal Reserve Banks and 24 branches. These banks are spread out across the country and have added sub-branches in order to provide for balanced representation around the geographic populations.

Why is the Federal Reserve important?

When a President is elected, his (or her) philosophies are poured into the legislation created during their time in office. For instance, President Trump’s “build the wall” agenda connects with his philosophy that makes sealing the border a priority. An often-overlooked aspect of the Fed is that it can allow the President to advance certain agendas that may be too unpopular to promote during a presidential campaign. For instance, President Obama rarely mentioned during campaign debates that he adheres to a Keynesian economist philosophy, which generally favors big government and heavy financial regulation.

By appointing Janet Yellen in 2013 as Fed Chair, Obama made it easier to push his Keynesian, high regulatory agenda, while rationalizing his appointment with generalities like saying Yellen is known for her good judgment. Therefore, Obama was able to push his unspoken agenda without ever having to state it publicly.

Though the Fed’s objective is well known, how it accomplishes its goals can be heavily debated. President Trump for instance, prefers more of a laissez-faire approach to handling the economy. That philosophy undoubtedly played a part in his decision to interfere with Yellen serving a second term, and instead appointing someone with who believes in more of an “invisible hand” free market system.

How does the Federal Reserve affect us?

One way to answer this question is by asking if there have been fewer financial crises have occurred since the Fed was introduced in 1913. The short answer is that there have been fewer financial catastrophes since 1913. With or without the Fed, however, financial crises will continue to exist. Additionally, just as the Fed could be credited with steering the financial system clear of numerous potential pit falls over the years, they’ve also created problems that might not have existed without their presence.

The perfect example? The crisis of 2008. While the Panic of 1907 materialized during a time when the market determined interest rates, the crisis of 2008 emerged on the heels of the Fed lowering interest rates to outlandishly low figures. This essentially made money free to borrow, and created a catastrophe that the invisible hand likely wouldn’t have perpetuated. Many do contend that the Fed’s response to the crisis ultimately mitigated what would have been far worse disaster. But, despite their clean-up efforts they weren’t free from harsh criticism.

Is the Federal Reserve achieving stability?

One of the more common ways to measure an economy’s stability is by examining the inflation rate of the corresponding currency. From the 1860 until today, the US dollar has experienced an average inflation rate of 2.14% per year. This is remarkably close to the targeted inflation rate of 2% that the Fed strives for.

The annual inflation from 1913 until 2018 shows a significantly higher rate of 3.1%. This 1% difference has significant consequences for American investors.

Investing during the era of the Fed means that historic bond rates will likely keep pace with inflation and to beat 3.1% investors need to take on higher risk levels to achieve actual returns vouched for by a consumer price index.

All in all, though, the Fed has managed to keep inflation at an acceptable rate, especially when compared to inflation on a global level. To illustrate, here are inflation rates from other currencies over the last 100 years:

Australia – 4%

UK – 4.6%

China – 5%

Brazil – 6.68%

Greece – 8.5%

While these historic inflation scores have plenty of meaning, the even bigger issue is the short-term volatility with foreign countries that won’t show up in historical longitudinal data. For example, Brazil experienced an 82% inflation rate disaster during a single year in the 1990s. This is something that probably would’ve been avoided if Brazil had a Fed-like entity monitoring inflation. Short-term volatility is something that should be accredited with much of the cryptocurrency support as folks living with currency volatility are desperate to get their money into anything more stable as soon as possible. Cryptocurrency in general has global optimism for potentially being a more stable currency than a chunk of the volatile countries out there. The necessity of making money and then quickly converting it into a more stable currency isn’t something we can relate to in the US. We can probably thank the Federal Reserve for that to some degree.

Is the Federal Reserve a good thing?

There aren’t any reliable studies that can give us conclusive data to state how much better or worse our nation’s finances are because of the Federal Reserve’s presence. Still, the consensus is that our stability, unemployment levels, and financial catastrophe frequency rates have all been positively affected. This contention can’t be proven empirically, but at the very least the Fed’s presence has usually created more faith in America’s financial system. This is because although most Americans don’t intimately understand the structure or functionality of the Federal Reserve, they do understand the entity’s purpose. And that is to protect the US economy from market perils.

The biggest issue in the Panic of 1907 was that the public lacked faith in the banking systems and that there wasn’t an entity to iterate the trust that should have been kept in the system. In 1907, bankers like JP Morgan had to step in and educate US citizens about the need for keeping money within the banking systems. JP Morgan also was tasked with organizing what could be described as massive stimulus packages to save the economy. In my opinion, it’s better to put this responsibility in the hands of a central banking system than well-intentioned business men.

Overall, the Fed’s basic objectives are well-intentioned and good in theory. Many economists have moved away from being “invisible hand” purists and shifted to a small-government paradigm paired with a moderately regulatory Federal Reserve. This type of system might’ve sounded frightening in the early 1800s after barely gaining independence from a micromanaging governmental body, but in our mature country this new system appears to be a positive national protocol.

A Few Final Thoughts

By understanding the Federal Reserve’s objectives, we can first decide if we fundamentally believe in the ideology of the financial entity. Once we understand that entity’s objectives, we can observe the changes that the Fed is inducing on our otherwise naturally flowing economy. These regulatory actions appear to have made a positive impression on our economy over the past hundred years. But, much like the government, the Fed is made up of moving parts that are constantly changing. These moving parts move mostly in tandem with the types of philosophies that flow in and out of our elected offices. As the Fed is an extension of our public offices, we can hope to ensure the quality of Federal Reserve Board Members by diligently working to elect quality individuals in positions serving our country.

I personally believe in the Fed’s objectives, and believe it has been a positive influence on our nation’s financial systems for the past 100 years. Whether or not you agree that the Fed was the perfect answer for the Panic of 1907, hopefully understanding the entity better will make you a more aware and knowledgeable investor.

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Hi, I'm Darian! I am a twenty-something insurance professional working on my ultimate quest for financial freedom. I hope you enjoyed this article. Stick around to learn more about financial strategies to manage debt, save more, spend less, and live the life you want.